This post is by René Stulz of the Ohio State University Fisher College of Business.

Throughout the world, many large banks have seen most of their equity destroyed by the crisis that started in the U.S. subprime sector in 2007 and governments have had to infuse capital in banks in many countries to prevent outright failure. Many observers have argued that ineffective regulation contributed or even caused the collapse. If that is the case, we would expect differences in the regulation of financial institutions across countries to be helpful in explaining the performance of banks during the credit crisis. Other observers have criticized the governance of banks and suggested that better governance would have led to better performance during the crisis. Finally, it could be that banks were affected differentially simply because they had different balance sheets and profitability before the crisis for reasons unrelated to governance and regulation and that these characteristics affected their vulnerability to large adverse shocks. In a paper recently posted on SSRN titled “Why did some banks perform better during the crisis? A cross-country study of the impact of governance and regulation,” Andrea Beltratti and I investigate the possible determinants of bank performance, measured by stock returns, during the crisis for a sample of large banks, i.e., banks with assets in excess of $50 billion at the end of 2006, across the world.

One striking result is that banks with the highest returns in 2006 had the worst returns during the crisis. More specifically, the banks in the worst quartile of performance during the crisis had an average return of -87.44% during the crisis but an average return of 33.07% in 2006. In contrast, the best-performing banks during the crisis had an average return of -16.58% but they had an average return of 7.80% in 2006. This evidence suggests that the attributes that the market valued in 2006, for instance, a successful securitization line of business, exposed banks to risks that led them to perform poorly when the crisis hit. The market did not expect these attributes to be a source of weakness for banks and did not expect the banks with these attributes to perform poorly as of 2006.

An OECD report argues that “the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements”. We find no evidence supportive of such a statement in our data. There is no evidence that banks with better governance, when governance is measured with data used in the well-known Corporate Governance Quotient (CGQ score) perform better during the crisis. Strikingly, banks with more pro-shareholder boards performed worse during the crisis.

We use the database on bank regulation developed in Barth, Caprio, and Levine (2001, 2004) to examine the hypothesis that stricter regulation prevented bank losses during the crisis. We use indicators for the power of the regulators, oversight of bank capital, restrictions on bank activities, and the independence of the supervisory authority. When we compare the banks in the top quartile of return performance to those in the bottom quartile, the better performing banks have more restrictions on their activities, stronger oversight of bank capital, and a more independent supervisory authority. In multiple regressions, we generally find that a stronger supervisory authority has a negative impact on performance during the crisis and stronger bank capital oversight is associated with better performance. We interpret the negative coefficient on the strength of the supervisory authority as follows. If stronger supervisory authorities would have been more effective at preventing banks from taking risks before the crisis, we would expect a positive coefficient on that variable. A possible explanation for this negative coefficient is that once the crisis was ongoing, stronger regulators took more measures that were costly to shareholders to assure the survival of banks.

Bank balance sheets and bank profitability in 2006 are more important determinants of bank performance during the crisis than bank governance and bank regulation. Banks that had a higher Tier 1 capital ratio in 2006 and more deposits generally performed better during the crisis. As a result, the positioning of banks as of the end of 2006 is more important than governance and/or regulation in explaining the performance of banks during the next two years. Another way to explain our results is that banks were differentially exposed to various risks by the end of 2006. Some exposures that were rewarded by the markets in 2006 turned out to be unexpectedly costly for banks the following two years. Overall, the explanatory power of regulatory variables is small compared to the explanatory power of bank-level variables.

Overall, our evidence shows that bank governance, regulation, and balance sheets before the crisis are all helpful in understanding bank performance during the crisis. However, banks with more shareholder-friendly boards, which are banks that conventional wisdom would have considered to be better governed, fared worse during the crisis. Either conventional wisdom is wrong, as suggested by Adams (2009), or this evidence is consistent with the view that banks that took more risks rewarded by the market –perhaps because the market did not assess them correctly ex ante – before the crisis suffered more during the crisis when these risks led to unexpectedly large losses. Strong evidence supportive of the latter interpretation is that the performance of large banks during the crisis is negatively related to their performance in 2006. In other words, the banks that the market rewarded with largest stock increases in 2006 are the banks whose stock suffered the largest losses during the crisis.